Wednesday, July 24, 2013

The zero-lower bound is the well-known 0% floor that a note-issuing bank hits whenever it attempts to reduce the interest rate it offers on deposits into negative territory. Should the bank drop rates below zero, every single negative yielding deposit issued by the bank will be converted into 0% yielding notes. When this happens, the bank will have lost any ability it once had to vary its lending rate.

The ZLB is an artificial construct. It arises from the way the banking system structures the liabilities that it issues, namely cash and deposits. We can modify this structure to either remove the ZLB or find alternative ways to get around it. Much of the discussion over the econblogosphere over the last few years has been oriented around various ways to get below zero.

There is another artificial bound, this one to the upside—let's call it the 5% upper bound, or FUB. The FUB is an archaic bound. Up until 1854, the Usury Laws prevented the Bank of England from increasing rates above 5%. This constraint meant that for almost two centuries, the Bank of England's discount rate was bounded within a narrow channel that had as its upper limit the 5% mark as stipulated by the Usury Laws and a lower limit of 0% due to the existence of 0% yielding banknotes (see chart above).

Imagine that we had a time machine and transported the econblogosphere, still hot over the ZLB debate, back to 1809. What sorts of discussions would we be having if we had risen up against the FUB? Given that the conventional route of increasing rates was constrained by the usury prohibitions, what sort of unconventional monetary policies would bloggers be providing to the Directors of the Bank of England to deal with inflationary booms? Would this advice be symmetrical to the policies they have been advocating for escaping the ZLB?

1809 is a significant date because the convertibility of the pound into gold had been suspended for over a decade. Although convertibility would be resumed in 1821, England would be on a 'fiat' standard very similar to our own for another decade. In the years since suspension, the pound had gradually depreciated against gold and other European currencies. A healthy debate began to flourish over whether the Bank of England was responsible for the pound's depreciation (ie. inflation) or if external events such as crop failures were to blame. It was in that context that banker/economist Henry Thornton published his famous Enquiry into the Nature and Effects of the Paper Credit of Great Britain. Although Thornton was circumspect on the precise causes of the deprecation of the pound, he drew attention to the difficulties that the Usury Laws caused in controlling the volume of credit. Here is Thornton:

In order to ascertain how far the desire of obtaining loans at the bank may be expected at any time to be carried, we must enquire into the subject of the quantum of profit likely to be derived from borrowing there under the existing circumstances. This is to be judged of by considering two points: the amount, first, of interest to be paid on the sum borrowed and, secondly, of the mercantile or other gain to be obtained by the employment of the borrowed capital...

The borrowers, in consequence of that artificial state of things which is produced by the law against usury, obtain their loans too cheap. That which they obtain too cheap they demand in too great quantity.

Thornton pointed out that if there was a large deficit between the price at which a businessman could borrow from the Bank of England and the mercantile rate of profit—the rate at which the same businessman could invest the borrowed money—then the demand for and granting of credit would become excessive. While nudging the discount rate higher would normally be sufficient to reduce this excess, the laws against usury might prevent these increases from taking place.

If we were to drop Nick Rowe into the 1809 economic debate, he would complement Thornton quite well by making good use of the same pole-on-a-palm analogy he has so aptly used to explain the ZLB. Running an inflation targeting central bank is sort of like balancing a long pole upright in the palm of one's hand, says Nick. The bottom of the pole is the interest rate and the top is the inflation rate. As the pole starts to lean (ie. the price level begins to change), the holder needs to quickly move their palm far enough in the same direction (ie. interest rates must be changed) so as to stop the pole from falling over. A wall to the either the north or south impedes the holder's palm from moving sufficiently far and will cause the pole to tumble over.

Applying this analogy to monetary policy, the Directors of the Bank of England might be required to stop excess inflation by moving rates north of 5%. With the Usury Laws in place, the Director's efforts would be impeded. Nick's illustration is Thornton all over again.

Scott Sumner, Lars Christensen, David Beckworth, and other monetarist-types have been strong advocates of quantitative easing as a way to get below the ZLB. Whisk them back to 1809 and would they advocate getting above the FUB by quantity dis-easing, or QD — mass repurchases of Bank of England notes through the liquidation of the Bank of England portfolio of assets?

Assuming that the threat of QD is able to increase the expected purchasing power of the pound (just as the threat of QE is supposed to reduce the same), then the Directors could initiate a QD program to improve the real return on pound notes and deposits. As soon as the real return on notes and deposits exceeds real returns on capital, the inflationary boom will come to a halt. Conveniently for the Directors, the nominal 5% rate will have remained in place — only real rates will have increased — thereby allowing the Directors to abide by the Usury Laws.

What about New Keynesians like Paul Krugman? Promising to hold off on future interest rate increases after a recovery has begun is the sort of advice New Keynesians have given to the Fed as a way to bridge the ZLB. This is called providing forward guidance. As Krugman says, a central bank needs to "credibly promise to be irresponsible".

Parachute Krugman into 1809 and he would be counseling the Directors to do the opposite: hold off on reducing rates from 5% after a contraction had already set in. In other words, the Directors need to "credibly promise to be hard-asses." As long as this promise is taken seriously by the market, the promise of future monetary tightening translates into lower inflation in the present, and the real interest rate rises. This should reign in the inflationary boom. Much like Sumner and Christensen, Krugman's advice would allow the Director's to hold steady at the 5% nominal rate dictated by the Usury Laws, letting real rates do the job of reeling in prices and slowing down the economy.

What about Miles Kimball? Transport Miles back to 1809 and he'll probably be the most aggressive in the outright removal of the Usury Laws. Just as he is currently campaigning for the ability of central banks to set negative rates on deposits, I'm sure he'd by picketing outside of Parliament for the right of the Director's to bypass the Usury Laws and set 6-7% nominal rates.

Incidentally, what did the Directors of the Bank of England actually do? According to Jacob Viner, there is evidence that

bankers found means of evading the restrictions of the usury laws. In 1818, the Committee on the usury laws stated in its Report that there had been “of late years ... [a] constant excess of the market rate of interest above the rate limited by law.” Thornton notes that borrowers from private banks had to maintain running cash with them, and borrowers in the money market had to pay a commission in addition to formal interest, and that by these means the effective market rate was often raised above the 5 per cent level. Another writer relates that long credits were customary in London and a greater discount was granted for prompt payment than the legal interest for the time would amount to.

More convincing evidence that the 5 per cent rate was not of itself always an effective barrier to indefinite expansion of loans by the banks is to be found in the fact that the directors of the Bank of England, although they professed that they discounted freely at the rate of 5 per cent all bills falling within the admissible categories for discount, in reply to questioning admitted that they had customary maxima of accommodation for each individual customer and occasionally applied other limitations to the amount discounted.

In Paper Credit we find Henry Thornton verifying Viner's claim, noting the "determination, adopted some time since by the bank directors, to limit the total weekly amount of loans furnished by them to the merchants."

So the Director's preferred route for getting out from under the thumb of the Usury Laws was to maintain the 5% discount rate, but ration the quantity of loans issued at these rates, thereby limiting the quantity of credit in circulation. While this policy might not have been sufficient to prevent an inflationary boom, it may have prevented a hyperinflation from breaking out.

Before I sign off, I want to reverse something I said at the outset. I wrote that the 5% upper bound was archaic, but that's not entirely true. Sure, high interest rates are no longer illegal. But high nominal interest rates have never been politically palatable. Central bankers are not independent of politics, and therefore probably still operate with something akin to a 5% upper bound. Let's call it an "upper-ish" bound, or the point at which a central banker starts to get dirty looks from those who have the power to reappoint him. Central bankers may need to resort to unconventional techniques to free themselves of the upperish-bound. The Fed's motivations for adopting quantity targets in 1979, for instance, may have been such a technique. An overt jacking-up of interest rates to 15-20% would have been political suicide, goes the theory, so the FOMC chose to engage in a bunch of hand-waving about hitting money supply targets, thereby distracting would-be critics with a new set of monetary verbiage. This left Paul Volcker free to implement what would be at its peak a tremendously onerous 22%+ fed funds rate.

We're of course not anywhere near the upper bound these days, at least not in the developed world, but it's still an interesting puzzle to work through in order to help understand the current situation. Our investigation also offers a history lesson. In choosing to remove it over century ago, the FUB was revealed to be neither a law of nature nor a design of God. The FUB was a choice. Hopefully we'll eventually realize that the same applies to the ZLB.

Then there is the business about the Zim dollar, that one issue that makes every Zimbabwean wake up in a cold sweat, and one that every candidate should really avoid. We cannot use the US dollar forever, he [Mugabe] begins. We will have to look at ways of bringing back our currency, sometime in the future. There are uncomfortable murmurs. Mugabe appears to be thinking out loud. "Should we, should we not?" he asks himself. "What if we back our currency with all our gold? Wouldn't it be strong enough? Maybe not now, of course, but sometime in the future. Maybe we will talk to [Gideon] Gono, the Reserve Bank governor."

I'm sure the memories of the hyperinflation are too fresh in the minds of Zimbabweans for them to buy into the folly of letting the insane duo of Mugabe and his central banker, Gideon Gono, once again have their own printing press, even if that press is to be constrained by gold convertibility. Let's take a quick glance through the 2007 Reserve Bank of Zimbabwe (RBZ) annual report [link] for a refresher of what the two of them got up to the last time around. By then in the midst of a severe hyperinflation, the RBZ's 2007 report kicks off with a boilerplate disavowal of any responsibility for the plunge in the Zim dollar's purchasing power, blaming it on "supply side constraints, speculative activities, and adverse expectations."

The report goes on to describe a dizzying number of "support" programs set up by the RBZ. These include in no particular order:

A large quantity of the support provided via these RBZ programs went straight to Gono and Mugabe's friends and allies. Coincidentally, it would seem that Gono, while RBZ governor, has become one of the biggest chicken farmers in Zimbabwe, recently boasting in the press that he expects to be Africa's first chicken-farming billionaire. Even if Gono didn't fund his farming dreams by diverting funds from RBZ agricultural support programs to himself, his suppliers, or purchasers, the conflict of interest presented by Gono's twin roles as chicken farmer and chicken farm financier is breathtaking. It would be like putting Jamie Dimon in charge of the Fed, without requiring Dimon to resign from and sell his shares in JP Morgan.

Most of the RBZ's special lending programs, as well as the direct financing of the government carried out by the RBZ, were granted at rates far cheaper than the market rate. Whenever a central bank keeps its rate perpetually below the market rate, hyperinflation is the inevitable result. But in Gono and Mugabe's Alice in Wonderland world, their so-called support programs weren't the cause of the hyperinflation, but rather the cure to hyperinflation. How did the pair square this very odd circle? Here is Gono explaining the Farm Mechanization Program:

Many may wonder why Your Central Bank gets involved in some of these activities which, on the face of it, appear to be outside our core mandate of inflation fighting. Your Excellency, inflation remains our number one enemy and core business. Thirty three percent (33%) of that inflation relates to Food and Food items alone. It follows therefore that our attempts to boost agricultural productivity in collaboration with Government and other stakeholders is actually an ancillary and incidental part of our core business.

According to Gononomics, inflation is not something created by a central bank but an external enemy that must be fought. The RBZ's cheap loans to the farm sector didn't set off inflation, but rather they improved productivity and reduced food prices, thereby reining in inflation. Reality, of course, had something stern to say about this. The Zim dollar continued to plunge in value, eventually hitting zero a year after Gono's speech. Gono and Mugabe were appropriately stripped of their printing press by the course of events, and that is how the situation should stay.

I'll deal with a few reasons that might be put forward for the resurrection of the Zim dollar, and why these reasons are not sufficient to counterbalance the danger of giving our two hyperinflationistas their own currency.

1) First, many people complain of a "small change" problem in Zimbabwe. A paucity of US dollar coins in circulation means that it is difficult for someone purchasing, say, $1.85 worth of food with $2.00 to get back 15c in change. While we in the West might consider change to be an inconvenience -- it is heavy and clinks around -- in a country like Zimbabwe where the average daily income is only a few dollars, the lack of coinage is a major problem.

This is hardly an issue that needs to be solved by a new Gono dollar, though. One route that Zimbabwean shopkeepers have taken to make things easier is to provide change in by the form of gum, candy, or other small items. This isn't an ideal solution, but it is a start of sorts. Private bus owners give change in the form of coupons that can be redeemed for transportation at some later date. These coupons don't appear to be highly liquid, though. The South African five rand coin has been recruited to serve the role of a 50 cent piece, regardless of the actual exchange rate between rand and US dollars. This is fine for now, but as the USD-ZAR exchange rate changes over time, the use of rand coins as change in US dollar transactions may become computationally burdensome.

A better solution would be to allow private Zimbabwean banks to coin or print 10c, 25c, and 50c tokens/coupons that, when brought back to the issuing bank, might be converted into their dollar equivalent. This would require the regulatory blessing of the RBZ. The RBZ, unfortunately, seems to be extremely jealous of those who would print or coin currency. In a bizarre story from this spring, two "prophets" claimed to be able to create US dollars from scratch, those in their audience reportedly receiving "miracle money" in their pockets. Gono immediately investigated the duo, eventually clearing them of any wrongdoing. If so-called miracle money receives such scrutiny from the RBZ, one can be sure that bank-produced small change would have to jump through incredibly high hoops before being permitted.

Lars Christensen has alsodiscussed the small change problem in Zimbabwe, noting the potential for e-money to fill the gap. I won't go into any depth on this possibility since Lars has covered it in some detail.

2) A second purported reason for introducing a new Zim dollar is to provide for the lender of last resort. Since the RBZ can't print US dollars willy nilly, Zimbabwe banks can't turn to their nation's central bank when they need liquidity support.

We've grown so used to the idea of a lender of last resort that we rarely stop to consider that such a lender is not a necessary feature of an economy. Panama has been effectively dollarized since 1904 and for that entire time has been without a lender of last resort. Panamanian banks have adapted by holding relatively high levels of liquid assets as self-insurance [link]. Bank failures have been small and infrequent, with the only major crisis event being related to the Manuel Noriega incident in the late 1980s. [link]

Like Panamanian banks, Zimbabwean banks will adapt to the lack of lender of last resort by modifying their own banking practices to ensure that their balance sheets are sufficiently flexible to deal with liquidity crisis.

In sum, Zimbabwe's currency situation is better than it has been in years and will only improve as technologies and practices evolve to deal with the small change problem, and as banks position themselves to deal with potential liquidity shortfalls. A Mugabe/Gono attempt to bring back the Zim dollar, whether it be gold-backed or not, is thoroughly unnecessary. Should the duo succeed in linking a new currency to gold, it is probable that they'll quickly close the gold window in order to get back to their old ways, a scenario that no one wants. With any luck, Zimbabweans will throw the scoundrels out onto the street come election time. Mugabe and Gono certainly deserve it.

Thursday, July 4, 2013

I've been teaching myself a Javascript visualization library called D3. It gives the chart creator an incredible degree of control in making interactive web-based charts. My previous interactive charts, including my interactive Eurosystem balance sheet tool, have all used the Google Vizualization API, which is far less powerful than D3.

You may want to read my last post was on bitcoin alternatives in order to understand what I'm trying to get at in this post. In visualizing the cryptocoin market, I think it's important to convey information about both the relative size of each cryptocoin and the date on which it was born. In doing so I'm trying to illustrate how being the first mover engenders network effects -- early cryptocoins tend to attract the largest market share. I also want to capture the mini boom in new coins since May 2013. Below I've pasted a D3 visualization of this data. Users can interact with it by hovering the mouse over each circle. The code is here.

I'm sure that chart nerds will accuse me of unnecessarily using a circle chart. The areas of circles are not as easily compared by our eye as, say, lines with differing heights. A quick glance immediately picks up height differentials -- it takes more effort to pick out area differentials. Far better would be to use a chart like this:

The logarithmic scale in the above line chart adds resolution by rendering each alt-coin's bar more comparable to what would otherwise be a humongous bitcoin bar. If I had time, I'd allow the user to zoomover the busy part in 2013. The problem with this chart is that the lines get jumbled together when the births of new coins comes in bunches. In this respect, the circle chart is superior to the line chart since it can easily handle simultaneous births by overlaying the circles one on top of the other.

The other problem with my line chart is it really doesn't convey the sheer size of bitcoin. I think the circle chart is pretty successful in this respect. The blue dot that represents BTC is virtually spilling off the page. When I came up with the design for the circle chart, I was thinking about the chart below: